Monday, July 22, 2013

Apple, Google and Amazon: A Valuation Mystery

            In an earlier post, I noted that the value of a company’s equity equals its current book value plus the present value of all future expected excess earnings – earnings in excess of the cost of capital times a company’s book value.  Companies with great prospects are valued far in excess of their book value due to expectations of large future excess earnings.  Consequently, a good metric for measuring the market’s estimate of a company’s expected future success is the ratio of the market value to book value.

            What is surprising is that when this ratio is calculated for Apple, Google and Amazon the result appears to say that the three companies have markedly different prospects.  Using the most recent balance sheets for March 31, 2013 and stock price data for the same day, the market to book ratio is 3.0 for Apple, 3.4 for Google, and 14.1 for Amazon.  Are the future prospects that much brighter for Amazon than for Apple or Google?

            The answer is no and the clue to the mystery is in the past, not in future expectations.  In the last five years, Apple and Google (particularly Apple) have had immense earnings.  Rather than investing those earnings in their core businesses, or paying them out to shareholders, Apple and Google have built up large cash holdings which are included in book value but which are unrelated to the operations of the firm.  Because cash only earns its cost of capital, the excess earnings on these large cash holdings are zero, dragging down the market to book ratio.  Amazon does not have this drag because, somewhat ironically, its past earnings have been meager or even negative, so there is relatively little excess cash.

            A solution to the problem is to exclude cash holdings and recompute the market to book ratio for an adjusted balance sheet.  In effect, the ratio is computed using the book value of the company’s core business.  The calculation is a bit tricky because it requires a precise definition of a company’s “excess cash.”  Remember some cash is required to run a business.

            When I make the cash adjustments the ratios come out to be approximately 17 for Apple, 13 for Google, and 18 for Amazon.  It turns out that the market thinks the future for the three companies is quite comparable, initial appearances to the contrary.